NewEnergyNews: HOW THE REGULATOR WILL HANDLE CAP&TRADE/

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    Monday, September 14, 2009

    HOW THE REGULATOR WILL HANDLE CAP&TRADE

    Gensler testifies on cap-and-trade legislation
    September 9, 2009 (Futures Magazine)

    SUMMARY
    When the U.S. gets cap&trade, who will watch over it?

    Gary Gensler, Chair of the U.S. Commodity Futures Trading Commission (CFTC), testified to the Senate Committee on Agriculture, Nutrition and Forestry on the Commission’s readiness to administer a cap&trade system like the one proposed in the Waxman-Markey energy and climate legislation.

    Gensler identified 5 components to effective regulation of a cap&trade system: (1) Standard setting and allocation; (2) Recordkeeping (maintaining a registry); (3) Overseeing trade execution system; (4) Overseeing clearing of trades; and (5) Protecting against fraud, manipulation and other abuses.

    The CFTC Chair said his agency is the right choice to administer the “trade” part of the system (numbers 3, 4 and 5) and recommended the Environmental Protection Agency (EPA) or a comparable agency to manage the “cap” part of the system (numbers 1 1nd 2).

    Gensler insisted the CFTC’s previous experience with managing emissions in the acid rain cap&trade system and in voluntary greenhouse gas emissions (GhGs) cap&trade systems demonstrates it can be effective at regulating a mandatory national system if it has an adequate budget.

    click to enlarge

    COMMENTARY
    A lot of people understand cap&trade as synonymous with fraud and abuse.

    The recent toxic assets debacle involving Wall Street, the real estate markets and the banks left a deep wariness about any investments more complicated than the straightforward purchase of simple stocks and bonds.

    Yet here comes Congress and the Obama administration with plans to institute something called cap&trade. It seems like an idea from Europe. And it promises to somehow be the magic answer to global climate change?

    Cap&trade neither came from Europe nor the Obama administration. It originated in the U.S., at the University of Chicago, as a market-based approach to managing the negative consequences of economic competition. It was originally enacted by the first Bush administration, over the vehement doubts of Democrats about its effectiveness and potential for fraud and abuse, but proved effective against acid rain.

    The motto of the CFTC is: “Ensuring the integrity of the futures & options markets.” Integrity would be good. But is the CFTC the way to go?

    In An air of deceit;Was convicted smog-credit swindler Anne Sholtz part of shady international ‘money repatriation’ schemes?, Chip Jacobs of the Pasadena Weekly described a scam run by California Institute of Technology Professor Anne Sholtz that involved the cap&trade system operated by the Los Angeles Air Quality Mangagment District (AQMD) modeled on the system used to reverse acid rain in the early-to-mid 1990s.

    The Sholtz affair was brought to light when Republicans, already oppose cap&trade and have no vested interest other than associating the idea with a scam, demanded more information about it. Does that make it an example of why cap&trade is unworkable?

    The Sholtz case is immensely complicated because it involves not merely manipulations of the LA AQMD cap&trade system but a scheme perpetrated by a sophisticated group of scammers, possibly associated with the CIA, to reap huge profits from the illegal securing of international treasures, some via the black market. Because there was fraud and lies on every side, it is not entirely clear how involved Sholtz really was.

    Once Sholtz was financially and romantically seduced by a shady character into the pursuit of the international treasures, the affair turned into a movie-like action-adventure thriller and it was only a matter of time until she was found out. While she was subjected to prosecution, her psuedo-lover and the other maybe-CIA scammers who used her seem to have vanished.

    It is clear that cap&trade system regulators must study the Sholtz affair to better understand how to effectively regulate markets and minimize fraud, scheming and insider trading. Designers of the Regional Greenhouse Gas Initiative (RGGI) and the Western Climate Initiative (WCI), voluntary emissions markets in the Northeast and the West, are doing so, as are regulators at the EPA and other government agencies.

    But Professor Sholtz was caught and the affair proved the value of regulation and policing. It demonstrated the need for greater transparency and more potent enforcement. The question remains: Is the CFTC the agency to do that?

    More recently, Europeans have been scandalized by a carousel fraud perpetrated by seller-hustlers. A carousel fraud is a way to take advantage of the fact that some European Union nations require Value Added Taxes (VATs) and some do not. Most widely used in association with cellular telephones, it is also called the “missing trader” fraud because it is perpetrated by sellers of goods purchased in countries without VATs who then sell them in countries with VATs, collect the taxes and abscomb without paying the government its due.

    The carousel fraud can be and will be used on any saleable commodity. (click to enlarge)

    Though this hustle has been used by illegitimate sellers of emissions allowances, it is not so much a manipulation of emissions trading as of tax revenues. To the extent that it is an issue pertaining to emissions trading markets, it does not especially represent a threat. Customs agents are already rounding up perpetrators, who will surely move to another commodity until EU governments standardize their tax systems. (See Climate change campaign creates carbon crimes; Fraudulent permit trading surfaces in Europe)

    A U.S. cap&trade system will surely fall prey to its share of cons, scams and schemes. The CFTC or whoever is appointed watchdog will need to be aggressively vigilant.

    Probably the most misunderstood part of cap&trade is not actually a part of cap&trade at all. Those who disdain the ideas of global climate change and using a market-based tool to address it often ridicule the idea of offsets. They disdain it as “environmentalist penance” or discredit it as a modern version of “purchasing indulgences.”

    What is it really?

    Wikipedia’s excellent entry on the subject defines an offset as “a financial instrument aimed at a reduction in greenhouse gas emissions.” Measured in metric tons of carbon dioxide-equivalent (CO2e) and applying to all 6 major greenhouse gases, 1 offset cuts 1 metric ton of CO2e. Offsets are traded in mandatory and voluntary markets.

    In mandatory markets, offsets can be used just like allowances to meet capped emissions. In voluntary markets, offsets are purchased to mitigate emissions. While the overall emissions of a country are affected by macroeconomic factors and may or may not be reduced, there is no doubt that each offset does reduce emissions.

    The main use of offset revenues is the building of New Energy infrastructure. Another important use of offset revenues is to protect forest lands. Both types of investments are sanctioned for use in meeting Kyoto Protocol targets by the United Nations Framework Convention on Climate Change (UNFCCC) through its Clean Development Mechanism (CDM). The CDM sells Certified Emissions Reductions (CERs), which like emissions allowances are validated to reduce 1 metric ton of CO2e.

    It's not a joke. (click to enlarge)

    Far from penance or the purchase of indulgence, offsets are certified to reduce emissions. But like any market, the offsets markets have loopholes. Those loopholes are being exploited. The biggest complaint against the CDM is that it certifies CERs for projects that would have been done anyway, making the obtaining of CDM certification little more than a financing strategy.

    click to enlarge

    A major emerging complaint against offsets has to do with those purchased to prevent deforestation. Deforestation may cause as much as 20% of the world’s GhGs. Preventing it, could significantly slow global climate change by sustaining the forests’ function as carbon “sinks.”

    click to enlarge

    The problem is that shady brokers, called “carbon cowboys” by environmentalists, have begun buying up, at very low prices, rights to emissions reductions owned by indigenous peoples in remote regions of the rainforests. Some of the brokers are buying at dirt cheap rates even before the CDM certifies the area as a legitimate deforestation prevention project.

    Eventually, the brokers profit greatly through the resale of CERs. The indigenous peoples remain impoverished. Often, the sale of CERs does not prevent the continuation of deforestation after the financial matters are settled.

    click to enlarge

    Recognizing the shortcomings of its system, the UNFCCC suspended its offset market in 2008 to tighten its regulatory efforts. When it was satisfied that effective changes were in place, it resumed its efforts.

    It will be crucial for the U.S. to see to the regulation of offset transactions if the cap&trade system passed by the Senate has, as the House bill does, provisions to allow deforestation offsets. Effective regulation will be key to the participation of U.S. market players in the preserving of the world’s precious and dwindling forests.

    The UNFCCC has streamlined and made more effective its certification process. (click to enlarge)

    Abuse can come in forms that are not fraud. ETS S.O.S.:Why the flagship ‘EU Emissions Trading Policy’ needs rescuing, from UK climate change and emissions trading specialist group Sandbag, reported that Europe’s biggest emitters are taking advantage of the continent’s cap&trade marketplace and making a killing at the expense of EU utility ratepayers and the world’s climate.

    More significantly, flaws in the ETS design threaten to allow the EU’s worst spewers to go unrestrained for the coming 7 years. (See EMISSIONS TRADING, A FLAWED BUT FIXABLE CAP&TRADE SOLUTION)

    Opponents of cap&trade jumped at the opportunity to use the Sandbag findings to their advantage but the report was not intended as a condemnation of the ETS. It was an attack on how the ETS is currently being implemented but was offered in support of reaching an agreement at the December international summit on climate change in Copenhagen to make the cap&trade system work better, not to imply the system should be abandoned.

    Sandbag wants the EU to fix its system, not abandon it. (click to enlarge)

    The report described the ETS as “a central plank” the EU’s effort to deal with climate change. Though the ETS could potentially be a sharp tool at cutting GhGs, it is currently blunted by 2 major flaws: (1) Too many permits are available. (2) The market has no provision to manage falling demand for permits.

    The ETS, according to Sandbag’s report, did not set strident enough emissions cutting goals and then issued too many permits to big emitters in the early stages of the system. The result was that permits were too abundant and therefore too cheap. It was too easy and too cheap to pay to spew.

    The assumption was that over time caps could be ratcheted down and excess permits would be used up. That was about to happen in 2008. The permit value had begun to stabilize. Then the worldwide economic downturn occurred. Emitters’ productivity fell off. They were generating fewer emissions and needed fewer permits.

    The ETS presently may have as many as 700 million surplus permits available for use through 2020.

    To make matters worse, the market was designed with the assumption there would be no need for a mechanism to cope with falling demand. Energy demand was expected to grow while caps were tightened.

    click to enlarge

    There was a mechanism designed into the system to protect the big emitters from demand that became too great and threatened to drive the price of generating emissions too high too fast. It was the availability of Certified Emissions Reductions (CERs) through the United Nations (UN) Framework Convention on Climate Change (FCCC) Clean Development Mechanism (CDM).

    Should ETS permits become scarce and drive the price up high enough to inhibit industrial activity in the EU, the designers reasoned, emitters could offset their spew by buying CERs for emissions reducing projects in emerging economies and undeveloped nations. Competition between the CER and ETS permits markets would keep both manageable.

    When the recession set in, there were as many as 1.6 billion excess ETS permits and CERs available through 2020.

    click to enlarge

    There is now no need for the big emitters to obtain new permits and the permits they now own make it possible for them to continue doing business without any cuts in GhGs through 2020. What’s more, the rules allow them to hold ("bank") up to 40% of current permits for use through 2020, so they may be able to continue spewing without penalty, according to Sandbag, for approximately the next 7 years if market demand remains constrained and productivity remains reduced.

    The worst short-term consequence is that the EU’s ability to provoke action by the international community at Copenhagen is now profoundly compromised. Its “central plank” in the climate change fight shows little effect and shows little promise of having an effect.

    The even worse long-term consequence is that, with too many permits sellers and too few buyers, the price of emissions is very low and is likely to remain so. The cap&trade system therefore is generating and will go on generating few revenues to invest in New Energy infrastructure. And it will not price emissions at a cost that will give big emitters any reason to invest. Without present investment in New Energy, there will be little New Energy in the future and GhGs will be the same devastating reality at the end of the 2nd decade of the 21st century that they are at the end of its 1st decade.

    The Sandbag report clearly took as its subtext that cap&trade could be made to work, given the right administration and regulation. It suggested a revised plan must be much more stringent with the big emitters. It wants the excess permits in the system cancelled.

    Gensler’s presentation to the Senate Committee made a series of valid points about why the CFTC is the right agency to administer and regulate a similar mandatory U.S. cap&trade system.

    Congress created the CFTC in 1974 to regulate U.S. commodity futures and option markets, which were then mostly agricultural. It has been renewed and expanded several times, most recently by the Commodity Futures Modernization Act of 2000, and now covers a wide spectrum of complex financial futures contracts. It guards market competitiveness and efficiency and protects against market fraud, manipulation, and abuse and assures transparency of price discovery for the offsetting of risk.

    Gensler pointed out that emissions allowances and offsets are similar to agriculture commodities. Emissions trading futures contracts are similar to financial products like Treasury-issued debt instruments, the most actively traded CFTC-regulated products.

    A cap&trade system would require the same kind of compliance monitoring the CFTC staff already does and the CFTC has extensive experience and a well-established program to regulate derivatives and the firms that handle such transactions. It knows the indications of manipulation, congestion and other market threats and it knows how to enforce and prosecute.

    In the past year, the CFTC has expanded the scope of its existing energy advisory committee to create the Energy and Environmental Markets Committee, which significantly enhances the CFTC’s ability to anticipate and address the full panoply of regulatory issues pertaining to emissions trading markets.

    The CFTC has instituted wide-ranging transparency efforts designed to provide as much information to the American public as possible. It is in a position to see that emissions futures and cash market transactions are reported promptly and the system’s registry is regularly and accurately updated daily. Transparency and prompt reporting, Gensler said, are key to identifying and stopping manipulation.

    Many in the energy and environmental communities have vivid memories of CFTC failures in the Spring and Summer of 2008 when trading on the CFTC-regulated oil futures market got out of hand and played a significant role of a rise in the price of oil to almost $150 per barrel.

    To prove they have learned their lesson and will fulfill their oversight responsibility, co-authors of the still-being-written Senate energy and climate legislation Senator Barbara Boxer (D-CA), Chair of the Senate Environment and Public Works Committee, and Senator John Kerry (D-MA), Chair of the Foreign Relations Committee, have said they will put stringent restrictions on the development of derivatives in the emissions trading markets.

    Is the CFTC up to the job? Will Congressional dictates prevent market havoc?

    The nation will be watching with interest to see how Congress and the Obama administration move to see that their system is protected.

    Present world emissions trading markets. Will the U.S. sign on? (click to enlarge)

    QUOTES
    - Gensler: “Over the past year, we have witnessed the consequences that regulatory gaps and inconsistencies can have on our financial system, the economy and the American people. As Congress moves forward with potential cap-and-trade legislation, I believe it should ensure that there is a comprehensive regulatory framework over the expanded carbon markets – both the futures market and the cash market – without exception.”
    - Gensler: “As Congress moves forward and possibly enacts cap-and-trade legislation, I look forward to working with this Committee to ensure that the new markets are comprehensively and effectively regulated. The CFTC is the exclusive regulator of futures markets. I believe that we have the expertise and experience necessary to help regulate the growth in carbon futures and cash markets that will occur if cap-and-trade becomes law. We must protect against the same hazards in the carbon markets that we currently guard against in other commodity futures markets: fraud, manipulation and other abuses.”
    - Chip Jacobs: “Hopeful as the White House is about cap-and-trade, even enthusiasts acknowledge that the complexities are jaw-dropping, with a market divided by geographic lines as well as industrial sectors. Roughly six billion tons of emissions could be traded yearly at first…Entities discharging more than 25,000 tons of greenhouse gases annually — non-nuclear power makers, oil refiners, natural gas producers, coal-fired steel plants, among others — will participate…Detractors believe with the money at stake, white-collar cheating is a certainty. Between now and 2035, greenhouse-gas permits may reach $5.7 trillion in value…Some investment houses are already gearing up to act as trade middlemen…”
    - Joel Kotkin, policy analyst: “Most of the people I talk to think [the market] will be set up for fraud…There’s scamming and then there’s scamming.”

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